Let’s Do The Math, Episode 1: Life Insurance

A friend of mine was meeting with a business mentor who took note of his recent marriage. The mentor prodded, “You have life insurance, don’t you?” My friend explained that he had been thinking about it and asked how much he should purchase. “Well, you’ve only been married a year, so your wife probably wouldn’t mourn too long. She’d remarry within a couple years, so you only need a few hundred thousand dollars.” My friend was taken aback at his frankness, but nonetheless appreciated the practical—albeit heartless—perspective.

Hundreds of miles away, another friend was asking his girlfriend’s father for permission to marry his daughter. The father’s response? Only if he first purchased life insurance. A day later, he got a call from his future father-in-law’s associate, quotes in hand.

Few categories are subject to more confident insistence than that of purchasing life insurance after marrying or becoming a parent. And for good reason. Most policies are relatively affordable, and the impact on those left behind can be life-altering. But for those of us already sold on the concept of life insurance, deciding how much to purchase is another question entirely. There are myriad rules of thumb among financial planners, but ultimately the decision is yours. Here, we’ve rounded up some of the most common guidelines for selecting a policy.

Don’t forget about debt.

If you’re in debt, don’t forget to subtract that debt from the total amount of your policy. Merely replacing your monthly income would still leave your beneficiaries in the red.

Account for inflation.

Yes, as time goes on, the cost of living will increase. But most financial advisors agree that the need for insurance benefits tend to decrease with age. After the age of 65, social security benefits and other retirement benefits begin to kick in, and most dependents will finally be independent. As such, inflation must be accounted for, but late-life disbursements need not equal in inflation-adjusted dollars if additional income streams will open up.

Limit monthly disbursements to interest for indefinite income.

The most conservative and lasting way to take income from a large sum is to limit your withdrawals to interest alone. A 5% return on a $500,000 lump sum, for example, would net $25,000 per year. By only taking $25,000 per year, the fund could produce income indefinitely. Comparatively, risk-averse beneficiaries who opt to lock the funds in an account without interest would enjoy just 20 years of $25,000 checks before the fund reached zero.

Ultimately, land and lock it in.

At the end of the day, you eventually need to land on a number and move forward before it’s too late. Here’s a formula we compiled from a number of different sources:

Annual income replacement x Number of Years of Need + Outstanding Debt + College Tuition x Number of College-Bound Dependents + Funeral Expenses – Savings – Other Income Sources = Total Need

Prefer to have someone else help you crunch the numbers? NerdWallet has an easy-to-use calculator that’s entirely free to use. The bottom line: life insurance is worthy of its constant concern. It’s the ultimate case for the phrase, “better safe than sorry.”